Frameworks for Valuation
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Transcript of Frameworks for Valuation
Frameworks for ValuationChapter 8 Summary . Erik Lloyd . April 23, 2007
OverviewPart 1:
What drives value & how to create value
value driven by ability to generate cash flows
long term growth returns on invested capital relative to
cost of capitalPart 2:Step by step guide to analyzing and
valuing a company First step (ch. 8)- Using DCF approach
to value a company
Valuing a company:DCF approach
Discounted Cash Flow models
1. Enterprise DCF model2. Economic Profit Model3. Adjusted Present Value (APV) Model4. Equity DCF Model
There are many ways to apply DCF approach
Enterprise and Economic discussed in detail
Both models provide the same value
Enterprise DCF Model
Most widely used model in practice Formula: Single-Business Company
Equity Value = Operating Value - Debt Value
Operating and Debt values are calculated by taking their respective cash flows and discounting at rates that reflect riskiness of these cash flows
Free cash flow from operations
Cash flow to debtholders
Cash flow to equity owners
Year 1 2 3 4 5
Discounted by WACC
Op
era
tin
g V
alu
e
De
bt
Va
lue
Eq
uit
y V
alu
e +
=
5064
6787 90
5043
332620
7090
100130
140
Equity Value = Operating Value - Debt Value
Or
Equity Value + Debt Value = Operating Value
Enterprise DCF Model
Formula: Multi-business Company Equity value = Sum of the values of the individual
operating units + Marketable securities - Corporate overhead - Value of company debt and preferred stock
1,750150 250
Unit D 2001,500
Unit C 300 300
P/ S 100
Unit B 400
1,100Unit A 700
Marketable securities
Value distribution
Value of operating units
Deb
tCom
mon
Equ
ity
Val
ue
Corporate Overhead
Enterprise Value
Equity value = sum of units + securities - overhead - debt and pref. stock
EXAMPLE: GM spinning off bus. lines or selling bus. Segments. They need to valuate how much four segments are worth.
Saturn
Saab
Insurance division
Residential mort. services
Value of operations Equals the discounted value of expected future
free cash flow Free cash flow =
after tax operating earnings + non-cash charges (deprec. etc.)
- investments in operating working capital, property, plant, and equipment, and other assets
Free cash flow = sum of the cash flows paid to or
received from all the capital providers
Enterprise DCF Model
Equity Value = Operating Value - Debt Value
Value of operations
The discount rate applied to the free cash flow should reflect the opportunity cost to all the capital providers weighted by their relative contribution to the company’s total capital, or WACC
opportunity cost is the rate of return the investors could expect to earn on other investments of equivalent risk
Enterprise DCF Model
Value of operations
How to include indefinite life of a business? Separate the value of the business into two periods
during a precise forecast period after a precise forecast period
Value = present value of cash flow during precise forecast period + present value of cash flow after precise forecast period
The value after the precise forecast period is the continuing value
Continuing value = NOPLAT (1-g/ROICi)
WACC-g {page 136}
Enterprise DCF Model
Value of debt Equals the present value of the cash flow
to debt holders discounted at a rate that reflects the riskiness of that flow
Value of equity Equals the value of the operations plus
non-operating assets, less the value of its debt and any non-operating liabilities
Enterprise DCF Model
WACC Summary Hershey Foods
Debt 12.1% 5.5% 39.0% 3.4% 0.4%Equity 87.9% 8.1% 8.1% 7.1%
WACC 7.5%
Contribution to weighted average
Proportion of total capital
Source of
CapitalOpportunity
cost Tax rateAfter-tax
cost
Free Cash Flow Valuation Summary
Year Free cash flow (FCF) Discount Present Value of FCFFactor
($ million) -7.50% ($ million)1999 331 0.93 3082000 349 0.865 3022001 364 0.805 2932008 485 0.485 235
Continuing value 14,710 0.485 7,1389,855
Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385
Drivers of Free Cash Flow and Value(evaluate FCF used for valuation)
1. The rate at which the company is growing revenues Growth Rate = ROIC x Investment rate
2. Return on invested capital (relative to the cost of capital, or WACC) ROIC = NOPLAT / Invested capital
If ROIC > WACC , then value is greater If ROIC = WACC, then value is neutral If ROIC <WACC, then value is destroyed
Enterprise DCF Model
Drivers To increase value, a company must do one
or more of the following1. Earn a higher return on invested capital 2. Ensure that ROIC (new) exceeds WACC3. Increase the growth rate (keeping ROIC
above WACC)4. Reduce WACC
Enterprise DCF Model
Growth Rate & Free Cash Flow
5% Growth rate ($ millions)
Year 1 2 3 4 5 6 7 8 9 10 11 12NOPLAT 100 105 110 116 122 128 134 141 148 155 163 171Net Investment 25 26 27 29 31 32 33 35 37 39 41 43Free cash flow 75 79 83 87 91 96 101 106 111 116 122 128
8% Growth rate ($ millions)
Year 1 2 3 4 5 6 7 8 9 10 11 12NOPLAT 100 108 117 126 136 147 159 171 185 200 216 233Net Investment 40 43 47 50 54 59 64 68 74 80 86 93Free cash flow 60 65 70 76 82 88 95 103 111 120 130 140
Invested 20% operating profits
Invested 40% operating profits
How ROIC and Growth Drive Value
DCF Value
Operating profit ROIC(annual growth) 7.50% 10.00% 12.50% 15.00% 12.00%
3% $887 $1,000 $1,058 $1,113 $1,1706% $708 $1,000 $1,117 $1,295 $1,4429% $410 $1,000 $1,354 $1,591 $1,886
Value Value Value Destruction neutral creation
Assumes starting NOP LAT = 100, WACC = 10%, and a 25-year horizon after which ROIC = WACC
Reasons for recommending the enterprise DCF model:
1. The model values the components of the business (each operating unit) that add up to the enterprise value
2. The approach helps to identify key leverage areas
3. It can be applied consistently to the company as a whole or to individual business units
4. It is sophisticated enough to deal with the complexity of most situations, yet easy to carry out with personal computer tools
Enterprise DCF Model
Enterprise DCF ModelEnterprise DCF model: Single-Business Co.
*Equity Value = Operating Value (minus) Debt Value
Operating Value: Value of Debt:
Discounted Value of exp. future Free Cash Flow PV of the cash flow to debt holders discounted at rate that
reflects riskiness of that flow WACC Free cash flow = after tax operating earnings
+ non-cash charges (deprec. etc.) - investments in operating working capital,
Debt % * cost property, plant, and equipment, and other assets Equity % * cost OR
wacc sum Free cash flow = sum of the cash flows paid to or received from all the capital providers
* Equity Value: Equals the value of the operations plus non-operating assets, less the value of its debt and any non-operating liabilities
Economic Profit Model Value equals the amount of capital invested plus a
premium equal to the PV of the value created each year.
Useful measure for understanding a company’s performance in any single year.
Economic Profit equals the spread between ROIC and the cost of capital times the amount of invested capital
Economic profit = Invested capital x (ROIC - WACC)
Translates the two value drivers (growth and ROIC) into a single dollar figure
Example: Economic profit = $1000 * (10%-8%)= $1000 * 2%= $20
Economic Profit Model Economic Profit is the after-tax operating profits less a charge
for the capital used by the company
Economic Profit = NOPLAT - Capital charge = NOPLAT - (invested capital x WACC)
The approach says that the value of a company equals the amount of capital invested plus a premium or discount equal to the present value of its projected economic profit
Value = Invested capital + present value of projected economic profit
Economic Profit Calculation
Forecast Forecast Forecast$ million 1997 1998 1999 2000 2001Return on invested capital 24.30% 23.0$ 23.00% 22.70% 22.60%WACC 8.30% 7.50% 7.50% 7.50% 7.50%Spread 16.00% 15.50% 15.50% 15.20% 15.10%Invested capital (beginning of year) 1,815 1,885 1,830 1,919 2,005Economic profit 291 293 283 292 304NOPLAT 442 434 420 436 454Capital charge (151) (141) (137) (144) (150)Economic profit 291 293 283 292 304
Economic profit = Invested capital x (ROIC - WACC)
Economic Profit = NOPLAT - Capital charge = NOPLAT - (invested capital x WACC)
YearEconomic Profit
Discount Factor
Present Value of Economic Profit
($ million) (7.5%) ($ million)
1999 283 0.930 2632000 292 0.865 252
2008 403 0.485 196Continuing value 11,858 0.485 5,754Present value of economic profit 8,024Invested capital (beginning of year) 1,830
9,857Mid-year adjustment factor 1.037Value of operations 10,217Value of non-operating investments 450Total enterprise value 10,667Less: Value of debt 1,282Equity value 9,385
Economic Profit Valuation Summary
FCF Valuation SummaryEquity Value 9,385
Economic Profit Valuation Summary
Equity Value 9,385
Adjusted Present Value (APV) Model
The APV model discounts free cash flows to estimate the value of operations, and ultimately the enterprise value, where the value of debt is then deducted to arrive at an equity value.
This is very similar to the enterprise DCF model, except: APV model separates the value of operations
into two components The value of operations as if the company were
entirely equity-financed The value of the tax benefit arising from debt
financing
Adjusted Present Value (APV) Model
The APV model reflects the findings from the Modigliani-Miller propositions on capital structure
In a world with no taxes, the enterprise value of a company (the sum of debt plus equity) is independent of capital structure (or the amount of debt relative to equity)
The value of a company should not be affected by how you slice it up
Adjusted Present Value (APV) Model
“Mr. Berra, would you like your pizza cut into six or eight pieces?”
“Six please, I am not hungry enough to eat eight.”
The pizza is the same size no matter how many pieces you cut into it!
Adjusted Present Value (APV) Model
The implications of MM for valuation in a world without taxes are
the WACC must be constant regardless of the company’s capital structure
Capital structure can only affect value through taxes and other market imperfections and distortions
Adjusted Present Value (APV) Model
The APV model
1) values a company at the cost of capital as if the company had no debt in its capital structure (the unlevered cost of equity)
2) adds the impact of taxes from leverage.
APV Free Cash Flow Valuation Summary
Year Unlevered DiscountCost of Factor
($ million) Equity ($ million)
1999 331 7.80% 0.928 3072000 349 7.80% 0.860 301
2008 485 7.80% 0.472 229Continuing value13,526 7.80% 0.472 6,380
9,056Mid-year adjustment factor 1.037APV value of FCF 9,390
Free cash flow (FCF)
Present Value
APV Free Cash Flow Valuation Summary with Tax Impact
APV value of FCF 9,390
Value of debt tax shield 642
Non-operating assets 450
Total enterprise value 10,482
Less: value of debt 1,282
Equity Value 9,200
Page 149
APV FCF Valuation SummaryEquity Value 9,200
FCF Valuation Summary
Equity Value 9,385
Why is there a difference in the equity values?
Adjusted Present Value (APV) Model
Comparison…
In the enterprise DCF model, this tax benefit is taken into consideration in the calculations of the WACC by adjusting the cost of debt by its tax benefit
In the APV model, the tax benefit from the company’s interest payments is estimated by discounting the projected tax savings
The key to reconciling the two approaches is the calculation of the WACC
Adjusted Present Value (APV) Model
Relating WACC to the unlevered cost of equity assuming that the tax benefit of debt is discounted at the unlevered cost of equity
WACC = ku - kb (B/(B+S)) T
Where ku = unlevered cost of equitykb = Cost of debtT = Marginal tax rate on
interest expensesB = Market value of debtS = Market value of equity
Enterprise DCF Adjusted for Changing Capital Structure
The enterprise DCF model assumes that the capital structure and WACC would be constant every period However, the capital structure does change every year
A separate capital structure and WACC can be estimated for every year
Year WACC Discount(percent) Factor
($ million) (percent (7.5%) ($ million)1999 331 13.3 7.52 0.930 3082000 349 12.3 7.54 0.865 302
2008 485 13.1 7.52 0.483 234Continuing value 14,710 13.1 7.52 0.483 6,965
9,675Mid-year adjustment factor 1.037Value of operations 10,032Value of non-operating investments 450Total enterprise value 10,482Less: Value of debt 1,282WACC Equity Value 9,200
Free cash flow (FCF)
Debt/Total value
Present Value
APV Free Cash Flow Valuation Summary
Equity Value 9,200
Enterprise DCF Adjusted for Changing Capital Structure
Equity Value 9,200
The Equity DCF Model
The equity DCF model discounts the cash flows to the equity owners of the company at the cost of equity
Equity DCF Valuation Summary
Year DiscountFactor
($ million) ($ million)
1999 245 0.925 2272000 137 0.856 118
2008 193 0.460 89Continuing value 12,895 0.460 5,934Discounted equity cash flows 8,454Mid-year adjustment factor 357Value of non-operating investments 450Equity value 9,261
Equity cash flow
Present Value
The Equity DCF Model This model also needs to be adjusted
for the changing capital structure. It is necessary to recalculate the cost of equity every period using the following formula
ks = ku + (ku - kb)(B/S)
Where ks = levered cost of equity
Once the adjustment is made, the value using the equity DCF approach is the same as the APV approach and the enterprise DCF model with WACC adjusted every period
Equity DCF Valuation Summary
Year Levered Discountks Factor
($ million) (percent (percent) ($ million)
1999 245 13.3 8.16 0.925 2272000 137 12.3 8.13 0.855 117
2008 193 13.1 8.15 0.458 88Continuing value 12,838 13.1 8.15 0.458 5,880Discounted equity cash flows 8,393Mid-year adjustment factor 357Value of non-operating investments 450Equity value 9,200
Equity cash flow
Debt/Total value
Present Value
The Equity DCF Model
Once the adjustment is made, the value using the equity DCF approach is the same as the APV approach and the enterprise DCF model with WACC adjusted every period.
APV Free Cash Flow Valuation Summary
Equity Value 9,200
Adjusted Enterprise DCF Valuation SummaryEquity Value 9,200
Adjusted Equity DCF Valuation SummaryEquity Value 9,200
The Equity DCF Model
The equity DCF approach is not as useful as the enterprise model (except for financial institutions) because Discounting equity cash flow provides less
information about the sources of value creation It us not as useful for identifying value-creation
opportunities It requires careful adjustments to ensure that
changes in projected financing do not incorrectly affect the company’s value
It requires allocating debt and interest expense to each business unit, which creates extra work, yet provides no additional information.
Additional Models and Approaches
Option Valuation Models Models which adjust for management’s
ability to modify decisions as more information is made available.
DCF Approaches Using real instead of nominal cash
flows and discount rates Discounting pretax cash flow instead
of after-tax cash flow Formula-based DCF approaches
Summary of Models
Enterprise DCF
Economic Profit
APV
Equity DCF
Adjus
tmen
t Adjustment
Economic Profit Model
Advantage over DCF Model:
EP is a useful measure for understanding a
company’s performance in any single year, while
cash flow is notAPV ModelAdvantage over
Enterprise DCF Model:
APV is easier to use when the capital
structure is changing significantly over the
projection period
Equity DCF ModelAdvantage:
Simple and Straightfoward
Disadvantage:Provides less information
Requires careful adjustments
Enterprise DCF ModelAdvantage:
Values the componentsPinpoints key leverage
areasConsistent
Can handle complex situations
Easy to carry out